Risk and discount rate: an unhappy marriage

Since I left my former employer Shell in 2015 I have become exposed to opportunity evaluation practices elsewhere in business. I found that everywhere the same discussion takes place: whether or not to incorporate some measure of ‘risk’ in the choice of the discount rate. No one I spoke to really feels comfortable with that. And rightly so. Nevertheless, to my surprise, the approach is often applied in practice, influencing investment decision making.

So why should we not tinker with the discount rate to reflect opportunity ‘risk’?

Let’s first consider how we arrive at the discount rate. The starting point is the WACC, the weighted average cost of capital. This is the weighted average of the cost of debt and the cost of equity. The relative weights depend on the financing structure of the company in question. This WACC has some relation to the systemic risk associated with the company, but this is highly notional and incomplete. If we consider how usually the WACC is derived in practice, then it will to a certain degree reflect the systemic risk perception in the market of the sector in which the company is operating. But it will not substantially incorporate a view of the long-term uncertainty in that market. And it will not reflect any company specific risk, with the exception of the cost of debt which will be influenced by company’s credit rating.

What we see is that companies will apply a ‘risk premium’ on top of the WACC, with its weak relation to risk to start with, to account for the risk in a particular investment category. For example, the degree of perceived country risk may call for the addition of several % to arrive at a country specific discount rate. Using magic, country risk ratings are translated to risk premiums. The same applies for different categories of investment projects. For example, investments in solar are discounted differently than investments in wind energy. Do we really know what we are doing here?

The crux is that we should not apply the mental model of ratings and risk premiums, that may work at the abstraction level of stock assets and entire companies, to individual capital investment projects. At this latter level there is a lot more granularity and opportunity (and need) to truly understand what is going on, and thus assess the risk.

So, open up the hood and get in there!

The right alternative is the following approach. A company is assumed to be a single economic entity with its own financing structure, thus having a single cost of capital. This is the basis for a discount rate which is a fixed, rounded and static number which acts as a yardstick when evaluating cash flows of all investment opportunities that the company may be considering. In this way we are evaluating projects like for like and account for the time value of money. Only in a situation of a substantive and long-lasting change within the underlying assumptions applicable to the company should it consider to adapt the WACC.

But of course, lots of attention should be devoted to assessing uncertainty and risk. In the first place this is accomplished by thinking in ranges rather than in single numbers. This leads to application of the methods of probabilistic investment analysis. Secondly, the well-established risk management and quantification practices come in useful. Thirdly, to better understand the uncertainty in the business environment, a company should think of applying scenario planning methodologies.

If these approaches are followed in an integrated way, rather than tinkering with the discount rate, a company will achieve that opportunity risks are much better understood leading to improved investment proposals and decisions.